One of the major contributors to world economic growth and development in the post-World War II years has been the ability of capital to flow relatively freely throughout most of the world. As capital began to flow more freely throughout the world in the late 1950s and 1960s, the rules of international monetary affairs changed. One of the most dramatic changes resulting from this freer movement of capital was the breaking down of the Bretton Woods system which finally breathed its last breath on August 15, 1971 as the United States removed itself from the gold system and began to float the dollar.
We are now experiencing some of the consequences of the free flow of capital throughout the world as the impact of the world’s central bank, the Federal Reserve System, is changing the behavior of nations.
One fear is that the changes are being made in the direction of imposing controls on the flow of
capital. As Nobel-prize winning economist Joseph Stiglitz has declared, the world seems to be evolving into fragments. Not exactly what the Federal Reserve had in mind.
This concern is captured by work being done within the International Monetary Fund that points to “the rising tensions as governments impose blocks on cross-border movements of speculative money.” (See “Surging Capital Flows Pull IMF into the Fray,” http://www.ft.com/cms/s/0/85907e38-1924-11e0-9311-00144feab49a.html#axzz1AGISipQS.)
“Emerging markets from Brazil to South Korea to Indonesia are complaining that a growing flood of money is boosting the value of their currencies and undermining their competitiveness. They have imposed different restrictions on investment to try to make sure those funds can’t leave the country suddenly.” (http://professional.wsj.com/article/SB10001424052748703675904576064233644690302.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj)
“Fundamentally, the IMF wants to expand its oversight of capital flows and determine when restrictions make sense and when they are being misused.”
Up to now, the implied culprit causing this situation to occur has been the monetary policy of the United States, specifically the program of Quantitative Easing (QE2) initiated and executed by Chairman Ben Bernanke and the Federal Reserve System. The low interest rates created by the Fed, keeping its Federal Funds target in the 0.0 to 0.25 basis point range since December 2008 while flooding the financial markets with more than $1.0 trillion in liquidity, has provided the catalyst for the international flows of speculative money.
As international tensions continue to grow, more and more explicit focus will be placed on the behavior of the Federal Reserve System. Experts are expecting that the whole issue of capital controls to become a “big part” of this year’s discussion of the G-20. French President Nicholas Sarkozy, chairman of the Group of 20 in 2011 is seen as a role-player in raising the international profile of the issue.
These international flows of speculative money are also being given credit for a good deal of the world-wide run-up in commodity prices. Speculative movements of funds have been given credit for increases in the prices of oil, gold, silver , and copper, among other non-food commodities.
Now, the rise in world food prices is gaining attention and concern. Today,the Financial Times leads with an article that includes the claim of “Food Price Shock” (http://www.ft.com/cms/s/0/524c0286-1906-11e0-9c12-00144feab49a.html#axzz1AGOW6ARZ). The Food and Agricultural Organization of the United Nations has warned that the world faces a “food price shock” as its benchmark index of farm commodities prices “shot up to a nominal record last month, surpassing the levels of the 2007-2008 food crisis.” This speculative crisis may be exacerbated if certain disturbing weather forecasts for 2011 are realized.
The concern is over the unrest that these higher food prices might have on potential unrest in many developing nations. There is even fear that this unrest could reach some developed countries including those in the Eurozone.
There has been growing discussion about the role that the Federal Reserve has played in the explosion of commodity prices throughout the world. Again, there are lots and lots of dollars “out there” and the cost of borrowing dollars is close to zero, especially in markets that are experiencing various degrees of inflation. Of course, this leads to the question of “bubbles”.
No one has really gotten a handle on the concept of credit bubbles and so there is a lot of discussion about what a credit bubble actually is, if credit bubbles even exist. Like pornography, credit bubbles seem to be whatever an observer wants to define them as.
Debate still exists about the “housing bubble” of the early 2000s. Again, the Federal Reserve kept its target interest rate extremely low for “an extended period of time” in order to insure that the economy did not collapse into a severe recession. Housing prices exploded in this period at double-digit rates of increase every year. The Fed Chairman at that time, Alan Greenspan, still refuses to acknowledge the existence of anything like a bubble in housing prices. Economist Ben Bernanke provided Greenspan with the justification for not acknowledging that a bubble took place.
So, a housing bubble took place in the early 2000s, unless it didn’t take place.
Is the flow of money into world commodity markets creating a credit bubble there? Is the flow of money into the currencies and stocks of developing countries creating a credit bubble there? Is QE2 the “bubble machine” of the world?
Something new has taken place in the world. The information Congress forced out of the Fed confirmed that the Federal Reserve System became the central banker of the world beginning in 2008. A consequence of this change in roles for the Federal Reserve is that, connected with the free flow of capital throughout the world, the Fed can become the “bubble maker” for the world. What the Fed does, does not stay at home!
I have frequently quoted the work of Raghuram Rajan, winner of the Financial Times/Goldman Sachs award for the best business book of 2010. (See a review of his award-winning book “Fault Lines,” http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan.) I now refer to a book written by Rajan fellow University of Chicago professor Luigi Zingales titled “Saving Capitalism from the Capitalists” (Princeton University Press). They write: “Bubbles are often pumped up by a whole new set of investors who do not have the experience or knowledge to invest carefully…There is no guarantee that even in a developed financial market the next new sector with limitless possibilities will not attract it own set of gullible investors.”
The international markets are attracting all sorts of money, a lot of it is money that is inexperienced in the investment in world commodities or the securities of emerging markets. These are the markets that have achieved a high profile in investment circles over the past twelve months or so.
QE2 seems to be working but maybe in ways that would not be recognized by Chairman Bernanke. But, he still denies that the early-2000s monetary policy of the Fed might have created a housing bubble.
Thursday, January 6, 2011
Tuesday, January 4, 2011
Where the Real Deals Will Be
Today, let’s put the conclusions of my first two blog posts of this year together. The second blog post discussed “Four ‘Uncomfortable’ Situations to Watch in Early 2011,’ (http://seekingalpha.com/article/244531-four-uncomfortable-situations-to-watch-in-early-2011). The basic point of this post is that there are four areas of the economy that bear watching because the situations that exist within these sectors are extremely fragile and could result in some kind of collapse in the future.
In my first blog of the year, “Economic Policy in the Decade of the Twenty-Tens: More of the Same” (http://seekingalpha.com/article/244325-economic-policy-in-the-decade-of-the-twenty-tens-more-of-the-same), I argued that the federal government will continue to follow the same economic policy philosophy that it has followed for the previous fifty years. I have called this a policy of “credit inflation.” The focus of this policy is to keep unemployment as low as possible for as long as possible over time. The consequence of this policy has been the massive growth of debt over this fifty-year period and the financial innovation that has accompanied the growth.
A consequence of the first situation is that there may be a substantial amount of distressed assets around that can be purchased very, very cheaply.
The consequence of the second situation is that the federal government will do all it can to keep the first situation from spiraling downward.
The opportunity? There will be a lot of assets available for sale at very cheap prices.
The means? There will be a lot of government money around that can be obtained very cheaply to acquire these assets!
We already see that the latter situation already exists. Yesterday I quoted Gillian Tett of the Financial Times reflecting on the easy monetary and fiscal policies of the last two years and the peace they have brought the financial markets: “While a sense of peace might have returned to parts of the financial system in the past two years, this has only been achieved by virtue of government aid - and rock-bottom interest rates.”
Will this continue?
Ben Bernanke, at the Fed, has begun the program of acquiring $900 billion in U. S. Treasury bonds to provide more liquidity to the financial system and keep long-term interest rates from rising. This is just a part of what I call the policy of “credit inflation.” The United States government is not going to let this recovery collapse if it can avoid it. Therefore, Bubble Ben will continue to throw more-and-more spaghetti against the wall (http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing).
But, that will not be all if further problems are recorded in the four problem areas I mentioned in yesterday’s post. The areas I focused on yesterday were the sovereign debt problem in Europe, the fragility of state and local finances in the United States, problem loans in the commercial real estate area, and the solvency of many of the 7,800 or so commercial banks in the United States banking system that make up about one-third of all the banking assets in the country.
In terms of the sovereign debt problem in Europe, the European Central Bank (ECB) is already committed to buy billions of Euros worth of sovereign debt of European Union countries in order to stem the financial crisis on the continent. Also, we know from the statistics related to the financial meltdown of 2008 and 2009 that the United States central bank, the Federal Reserve System, has really become the central banker to the world.
Will these institutions, as well as the European Union, itself, not try to put a floor to the prices of sovereign debt?
And, what about the fiscal dilemma facing state and local governments in the United States?
The ground is already shifting. State governments are starting to write laws that will lessen the power of government labor unions…even in New York and New Jersey and other states that have been pro-labor for years. Furthermore, do you really think state governments and the federal government are going to let local governments just fail? Do you really think that the federal government is going to let state governments fail? (See “When States Default: 2011, Meet 1841,” http://professional.wsj.com/article/SB10001424052748704835504576060193029215716.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.)
And, what about a collapse in the commercial real estate market? The reason that loans in this area have been buoyed up for so long is to buy time for the FDIC in dealing with smaller commercial banks who have a disproportionate amounts of these loans on their balance sheets.
Many of these banks are going to need to be closed in one way or another (3,000 as Elizabeth Warren warned) and the FDIC just cannot handle more than three to four closing a week at the present time. As this process continues, the Federal Reserve and the federal government cannot remove the liquidity now in the system and threaten higher interest rates and foreclosures on these distressed properties.
The bottom line is that a lot of “stuff” is going may be coming on the market in the next twelve months or so and the prices of these assets are going to be very attractive.
The downside risk?
The federal government is going to try and take away as much of this risk as possible. The “Greenspan Put” has now become the “Bernanke Put.”
The federal government will do all it can to maintain or improve the employment situation and it will do all it can to bailout sectors of the economy experiencing significant financial difficulties in order to prevent a double dip in the economy.
Thus, opportunities to purchase distressed assets may be plentiful in such a scenario. And, just remember, large banks and large corporations have billions and billions of dollars of cash on hand to purchase these assets. This is true for the United States, http://dealbook.nytimes.com/2011/01/03/confident-deal-makers-pulled-out-checkbooks-in-2010/?ref=business, and for Europe http://professional.wsj.com/article/SB10001424052748704111504576059450313071700.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj. And, if they don’t have the cash on hand, they can just borrow it for next to nothing.
Wealthy individuals and developers are also moving in this area. The amount of activity picking up provides vivid support for the fact that distressed properties are already being scooped up, cheaply. It is likely, especially in real estate development to see a lot of distressed buying over the next year, but this will be "big bank" business because "smaller banks" don't usually do this kind of business and those that got into this kind of business have been burned, badly. Also, it will be business coming from hedge funds and private equity funds.
In my first blog of the year, “Economic Policy in the Decade of the Twenty-Tens: More of the Same” (http://seekingalpha.com/article/244325-economic-policy-in-the-decade-of-the-twenty-tens-more-of-the-same), I argued that the federal government will continue to follow the same economic policy philosophy that it has followed for the previous fifty years. I have called this a policy of “credit inflation.” The focus of this policy is to keep unemployment as low as possible for as long as possible over time. The consequence of this policy has been the massive growth of debt over this fifty-year period and the financial innovation that has accompanied the growth.
A consequence of the first situation is that there may be a substantial amount of distressed assets around that can be purchased very, very cheaply.
The consequence of the second situation is that the federal government will do all it can to keep the first situation from spiraling downward.
The opportunity? There will be a lot of assets available for sale at very cheap prices.
The means? There will be a lot of government money around that can be obtained very cheaply to acquire these assets!
We already see that the latter situation already exists. Yesterday I quoted Gillian Tett of the Financial Times reflecting on the easy monetary and fiscal policies of the last two years and the peace they have brought the financial markets: “While a sense of peace might have returned to parts of the financial system in the past two years, this has only been achieved by virtue of government aid - and rock-bottom interest rates.”
Will this continue?
Ben Bernanke, at the Fed, has begun the program of acquiring $900 billion in U. S. Treasury bonds to provide more liquidity to the financial system and keep long-term interest rates from rising. This is just a part of what I call the policy of “credit inflation.” The United States government is not going to let this recovery collapse if it can avoid it. Therefore, Bubble Ben will continue to throw more-and-more spaghetti against the wall (http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing).
But, that will not be all if further problems are recorded in the four problem areas I mentioned in yesterday’s post. The areas I focused on yesterday were the sovereign debt problem in Europe, the fragility of state and local finances in the United States, problem loans in the commercial real estate area, and the solvency of many of the 7,800 or so commercial banks in the United States banking system that make up about one-third of all the banking assets in the country.
In terms of the sovereign debt problem in Europe, the European Central Bank (ECB) is already committed to buy billions of Euros worth of sovereign debt of European Union countries in order to stem the financial crisis on the continent. Also, we know from the statistics related to the financial meltdown of 2008 and 2009 that the United States central bank, the Federal Reserve System, has really become the central banker to the world.
Will these institutions, as well as the European Union, itself, not try to put a floor to the prices of sovereign debt?
And, what about the fiscal dilemma facing state and local governments in the United States?
The ground is already shifting. State governments are starting to write laws that will lessen the power of government labor unions…even in New York and New Jersey and other states that have been pro-labor for years. Furthermore, do you really think state governments and the federal government are going to let local governments just fail? Do you really think that the federal government is going to let state governments fail? (See “When States Default: 2011, Meet 1841,” http://professional.wsj.com/article/SB10001424052748704835504576060193029215716.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.)
And, what about a collapse in the commercial real estate market? The reason that loans in this area have been buoyed up for so long is to buy time for the FDIC in dealing with smaller commercial banks who have a disproportionate amounts of these loans on their balance sheets.
Many of these banks are going to need to be closed in one way or another (3,000 as Elizabeth Warren warned) and the FDIC just cannot handle more than three to four closing a week at the present time. As this process continues, the Federal Reserve and the federal government cannot remove the liquidity now in the system and threaten higher interest rates and foreclosures on these distressed properties.
The bottom line is that a lot of “stuff” is going may be coming on the market in the next twelve months or so and the prices of these assets are going to be very attractive.
The downside risk?
The federal government is going to try and take away as much of this risk as possible. The “Greenspan Put” has now become the “Bernanke Put.”
The federal government will do all it can to maintain or improve the employment situation and it will do all it can to bailout sectors of the economy experiencing significant financial difficulties in order to prevent a double dip in the economy.
Thus, opportunities to purchase distressed assets may be plentiful in such a scenario. And, just remember, large banks and large corporations have billions and billions of dollars of cash on hand to purchase these assets. This is true for the United States, http://dealbook.nytimes.com/2011/01/03/confident-deal-makers-pulled-out-checkbooks-in-2010/?ref=business, and for Europe http://professional.wsj.com/article/SB10001424052748704111504576059450313071700.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj. And, if they don’t have the cash on hand, they can just borrow it for next to nothing.
Wealthy individuals and developers are also moving in this area. The amount of activity picking up provides vivid support for the fact that distressed properties are already being scooped up, cheaply. It is likely, especially in real estate development to see a lot of distressed buying over the next year, but this will be "big bank" business because "smaller banks" don't usually do this kind of business and those that got into this kind of business have been burned, badly. Also, it will be business coming from hedge funds and private equity funds.
Monday, January 3, 2011
What to Watch For in Early 2011
There are four situations in the financial area that require special attention in, at least, the early part of 2011. These situations pertain to the European debt problem, both sovereign and corporate, the problems being experienced by state and municipal governments in the United States, the problems connected with the rolling over of commercial real estate loans, and the consolidation that is taking place in the United States banking system.
The European situation seems to be the first out-of-the-box for the new year. Although most of the attention on Europe has been focused on the sovereign debt problem, the potential for problems to arise in the corporate sector should not be overlooked.
Europe cannot put its debt problems behind it because its leaders are not really facing up to the real problem. The real problem relates to the fiscal integration of the countries within the European Union.
As I have stated many times over the past year, a region cannot have just one currency if capital flows within the region are not restricted and if the political entities within the union continue to conduct their fiscal policies independently of one another. The European Union cannot be successful over time if it tries to maintain all three of these objectives.
Simon Johnson in “The Baseline Scenario” states that “Most experienced watchers of the eurozone are expecting another serious crisis to break out in early 2011. This projected crisis is tied to the rollover funding needs of weaker eurozone governments…” A solution will not be reached until the leaders of the European Union really face the fundamental facts of their crisis.
But, the sovereign debt of Europe is not the only concern. Although the corporate sector has been relatively successful in staying out of the limelight, concern is rising over what might happen here in 2011 if there are spillover effects coming from the “sovereign” sector. Especially worrisome is the amount of speculative-grade bonds maturing in the future and the potential number of defaults connected with the roll-overs. (See “Gearing up for 2011,” http://www.ft.com/cms/s/3/4b13a710-1363-11e0-a367-00144feabdc0.html#axzz19ypGKK7a.)
The second uncomfortable situation that is looming over 2011 is the fiscal soundness of many states and municipalities in the United States. Almost daily, new information comes out about the condition of our state and municipal governments, the cutbacks in police, firemen, educators, and social workers, the un-funded pension funds, and the labor unrest that is stirring because of the changes being proposed.
Bankruptcy is an issue. In some states, the bankruptcy of a municipality is unrecognized. For example, the situation in Hamtramck, Michigan is extremely bad, yet, the state of Michigan will not let the city declare bankruptcy. (See http://www.freep.com/article/20101205/NEWS02/12050500/Hamtramck-can-t-declare-bankruptcy-state-says.) Harrisburg, Pennsylvania and a host of other municipalities are just plugging holes attempting to avoid the worst.
But, many states are not doing much better.
And, the unrest in these areas continues to grow. However, this unrest is not just associated with the citizens losing services, the unrest is connected with the workers and the unions that are losing jobs and benefits. More than 50% of the union workers in the United States are in state and local governments so the potential conflicts with budget needs can be substantial. But, the times may be changing: “In California, New York, Michigan, and New Jersey, states where public unions wield much power and the culture historically tends to be pro-labor, even longtime liberal political leaders have demanded concessions—wage freezes, benefit cuts and tougher work rules.” (See http://www.nytimes.com/2011/01/02/business/02showdown.html?_r=1&scp=1&sq=public%20workers%20facing%20outrate%20in%20budget%20crisis&st=cse.)
Commercial real estate is another potential disaster area. For twelve months or more, commercial real estate loans have been on the list of major looming problems, in Europe as well as the United States. Yet, a crisis never seems to occur. One reason is that “banks on both sides of the Atlantic have been ‘ever-greening’ loans—or essentially extending the maturities, and practicing forbearance to avoid recognizing losses.” (See Gillian Tett, “Commercial Property Loans Pose New Threat”, http://www.ft.com/cms/s/0/c23e885e-1422-11e0-a21b-00144feabdc0.html#axzz19yRTp3ed.)
“Banks and borrowers have been able to conduct such ever-greening because interest rates have been rock-bottom low. But if rates rise, this ever-greening will be harder to maintain.”
Tett concludes with something we all need to keep in mind: “while a sense of peace might have returned to parts of the financial system in the past two years, this has only been achieved by virtue of government aid—and rock-bottom interest rates.”
As I have said over and over again, Federal Reserve policy has been aimed at achieving “a sense of peace” so that banks and others could work out of their debt problems: so that the FDIC could close banks in as quiet an environment as possible. And, some participants believe that the reduction in the size of the banking system will still be in the 1,000s over the next four or five years.
The question remains: has deleveraging taken place by a significant enough amount so that we can declare the bank crisis over?
The first three situations described above indicate that the deleveraging still has a ways to go and that as this deleveraging takes place the banks, in both the United States and Europe, could face further stress. There is certainly concern “out there” that the problems in the banking sector are not over. See, for example “Banks Pushed Together in a Wave of Deals,” http://professional.wsj.com/article/SB10001424052748704774604576035732836200772.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj, and “Bailed-Out Banks Slip Toward Failure,” http://professional.wsj.com/article/SB10001424052970203568004576044014219791114.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.
In terms of closing banks in an orderly fashion, another problem has existed: the FDIC has just not had the resources to act as quickly as needed to fully deal with those banks that are seriously facing financial difficulties. Thus, even in troubled banks, “ever-greening” is a methodology for keeping the doors open because this buys time and “who knows what might happen” if a bank can keep open. “There’s just not enough manpower and coordination to catch all these failing institutions at once.” For more on this see “Hard Call for FDIC: When to Shut Bank,” http://professional.wsj.com/article/SB10001424052970204685004576045912789516274.html.
I am not saying that it is a sure thing that we will face eruptions in these four areas in 2011. And, I am not saying that these four situations are the only ones to be looking at during the year. It is just that the problems that exist in these four areas have not been resolved and will have to be resolved at some time in the future for the economic recovery to really pick up steam. The interesting times are not over.
The European situation seems to be the first out-of-the-box for the new year. Although most of the attention on Europe has been focused on the sovereign debt problem, the potential for problems to arise in the corporate sector should not be overlooked.
Europe cannot put its debt problems behind it because its leaders are not really facing up to the real problem. The real problem relates to the fiscal integration of the countries within the European Union.
As I have stated many times over the past year, a region cannot have just one currency if capital flows within the region are not restricted and if the political entities within the union continue to conduct their fiscal policies independently of one another. The European Union cannot be successful over time if it tries to maintain all three of these objectives.
Simon Johnson in “The Baseline Scenario” states that “Most experienced watchers of the eurozone are expecting another serious crisis to break out in early 2011. This projected crisis is tied to the rollover funding needs of weaker eurozone governments…” A solution will not be reached until the leaders of the European Union really face the fundamental facts of their crisis.
But, the sovereign debt of Europe is not the only concern. Although the corporate sector has been relatively successful in staying out of the limelight, concern is rising over what might happen here in 2011 if there are spillover effects coming from the “sovereign” sector. Especially worrisome is the amount of speculative-grade bonds maturing in the future and the potential number of defaults connected with the roll-overs. (See “Gearing up for 2011,” http://www.ft.com/cms/s/3/4b13a710-1363-11e0-a367-00144feabdc0.html#axzz19ypGKK7a.)
The second uncomfortable situation that is looming over 2011 is the fiscal soundness of many states and municipalities in the United States. Almost daily, new information comes out about the condition of our state and municipal governments, the cutbacks in police, firemen, educators, and social workers, the un-funded pension funds, and the labor unrest that is stirring because of the changes being proposed.
Bankruptcy is an issue. In some states, the bankruptcy of a municipality is unrecognized. For example, the situation in Hamtramck, Michigan is extremely bad, yet, the state of Michigan will not let the city declare bankruptcy. (See http://www.freep.com/article/20101205/NEWS02/12050500/Hamtramck-can-t-declare-bankruptcy-state-says.) Harrisburg, Pennsylvania and a host of other municipalities are just plugging holes attempting to avoid the worst.
But, many states are not doing much better.
And, the unrest in these areas continues to grow. However, this unrest is not just associated with the citizens losing services, the unrest is connected with the workers and the unions that are losing jobs and benefits. More than 50% of the union workers in the United States are in state and local governments so the potential conflicts with budget needs can be substantial. But, the times may be changing: “In California, New York, Michigan, and New Jersey, states where public unions wield much power and the culture historically tends to be pro-labor, even longtime liberal political leaders have demanded concessions—wage freezes, benefit cuts and tougher work rules.” (See http://www.nytimes.com/2011/01/02/business/02showdown.html?_r=1&scp=1&sq=public%20workers%20facing%20outrate%20in%20budget%20crisis&st=cse.)
Commercial real estate is another potential disaster area. For twelve months or more, commercial real estate loans have been on the list of major looming problems, in Europe as well as the United States. Yet, a crisis never seems to occur. One reason is that “banks on both sides of the Atlantic have been ‘ever-greening’ loans—or essentially extending the maturities, and practicing forbearance to avoid recognizing losses.” (See Gillian Tett, “Commercial Property Loans Pose New Threat”, http://www.ft.com/cms/s/0/c23e885e-1422-11e0-a21b-00144feabdc0.html#axzz19yRTp3ed.)
“Banks and borrowers have been able to conduct such ever-greening because interest rates have been rock-bottom low. But if rates rise, this ever-greening will be harder to maintain.”
Tett concludes with something we all need to keep in mind: “while a sense of peace might have returned to parts of the financial system in the past two years, this has only been achieved by virtue of government aid—and rock-bottom interest rates.”
As I have said over and over again, Federal Reserve policy has been aimed at achieving “a sense of peace” so that banks and others could work out of their debt problems: so that the FDIC could close banks in as quiet an environment as possible. And, some participants believe that the reduction in the size of the banking system will still be in the 1,000s over the next four or five years.
The question remains: has deleveraging taken place by a significant enough amount so that we can declare the bank crisis over?
The first three situations described above indicate that the deleveraging still has a ways to go and that as this deleveraging takes place the banks, in both the United States and Europe, could face further stress. There is certainly concern “out there” that the problems in the banking sector are not over. See, for example “Banks Pushed Together in a Wave of Deals,” http://professional.wsj.com/article/SB10001424052748704774604576035732836200772.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj, and “Bailed-Out Banks Slip Toward Failure,” http://professional.wsj.com/article/SB10001424052970203568004576044014219791114.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.
In terms of closing banks in an orderly fashion, another problem has existed: the FDIC has just not had the resources to act as quickly as needed to fully deal with those banks that are seriously facing financial difficulties. Thus, even in troubled banks, “ever-greening” is a methodology for keeping the doors open because this buys time and “who knows what might happen” if a bank can keep open. “There’s just not enough manpower and coordination to catch all these failing institutions at once.” For more on this see “Hard Call for FDIC: When to Shut Bank,” http://professional.wsj.com/article/SB10001424052970204685004576045912789516274.html.
I am not saying that it is a sure thing that we will face eruptions in these four areas in 2011. And, I am not saying that these four situations are the only ones to be looking at during the year. It is just that the problems that exist in these four areas have not been resolved and will have to be resolved at some time in the future for the economic recovery to really pick up steam. The interesting times are not over.
Saturday, January 1, 2011
Economic Policy in the Decade of the Twenty-Tens: More of the Same
Happy New Year!
I have spent a good portion of the last week and a half reviewing my perception of the foundational philosophy undergirding the economic and financial policies of governments in the United States and Europe and I come to the same conclusion over and over again.
Governments in the United States and Europe and the people working in and for them have learned little or nothing over the past fifty years.
These governments are still united in their belief that continuing credit inflation is what their economies need. It is the policy that they plan on delivering. And, if troubles develop, then they just bail troubled institutions out and continue on their merry way. Europe, in the first quarter of 2011, seems to be headed for another round of this bail and run behavior.
The underlying rationale for this is that the leaders of these governments believe that every effort must be made to keep unemployment as low as possible for as long as possible by aggregate governmental actions.
These leaders are unwilling to accept the fact that their policies only make it harder for them to achieve their goal over time and just applying more and more stimulus to the economy will just make things worse.
It is not enough to see that, in the United States alone, underemployment has gone from around ten percent in the 1960s to about twenty-five percent now and that over these past fifty years the income distribution has become more and more skewed toward the higher income end of the spectrum.
The reasons for these results? First, you cannot keep putting people back in their legacy jobs by means of fiscal and monetary stimulus and expect them to maintain their productivity and job competitiveness in a fast changing world. Second, credit inflation can only be taken advantage of by the wealthier people in the country; the less wealthy in such an environment, even though they might be benefitted by it in the short run, lose out to the wealthier over the longer run.
Stock markets, of course, like this environment of credit inflation. Note the following measures of stock market performance. Here we have charted Bob Shiller’s CAPE measure (Cyclically Adjusted P/E Ratio) and Jim Tobin’s q ratio. These statistics, obviously, roughly measure
the exact same thing, whether or not the capital stock in the United States is over- or under-valued. In the 1960s and early 1970s equities seem to be overvalued as the period of credit inflation gets underway. In the late 1970s, of course, we get the period of extremely tight monetary policy aimed at thwarting the rapid acceleration taking place at the time. However, the 1980s revived the bias toward credit inflation, and, as can be seen, the stock markets seemed to take advantage of this policy stance as both measures never dropped below their long-term averages even through the “Great Recession” up to the present time.
This fifty year period was, of course, the time in which the financial sectors of the economy grew to become such a large proportion of the economy and it was the heyday of financial innovation.
It was not the less-wealthy part of the country that benefitted from this policy stance over this period of time.
If the current foundational policy stance of the government remains one of credit inflation similar to the one in place for the last fifty years then all we can expect is more of the same.
And, in my mind, there is no separating out Republicans or Democrats on this issue. Both have proven equally committed to the same policy stance (just using different words to justify it) and both seem to remain oblivious to the facts.
Also, in my mind, the amount of debt people carry matters, but many of our policymakers seem to believe that the existence of debt carries with it no consequences. In fact, the belief seems to be that the solution to the problem of too much debt outstanding is the creation of even more debt. And, if the amount of debt outstanding seems to be troublesome, well, then just let a central bank buy it.
I see nothing on the horizon to change my mind concerning the economic philosophy that serves as the foundation for policy making in the United States and Europe. Credit inflation remains the underlying stance of the economic policies of these governments for future.
Thus, we can expect, over the next decade, a continuation of the economic and financial environment of the last fifty years.
Wednesday, December 22, 2010
Commercial Banking in 2011
Commercial banking in the United States is going to change substantially in the next five years.
Most of my comments on the banking industry over the past year have been spent on the “smaller” banks, the banks are not among the 25 largest commercial banks in the industry, the banks that control about 30% of the banking assets in America. At last count there were a little less than 7,800 of these banks. The average size of the banks in this category is about $480 million, pretty small.
My concern about these banks is their solvency. The FDIC placed 860 commercial banks on its list of problem banks at the end of the third quarter. The question that is still outstanding is how many more banks are seriously challenged to remain in business. That is, how many banks are not on the problem list but “near” to being on the problem list. Elizabeth Warren gave testimony in front of Congress in the spring and stated that 3,000 commercial banks were threatened by bad loans over the next 18 months.
Commercial banks have been closed at the rate of approximately 3.5 per week during 2010 and many other acquisitions have taken place. So, the industry is shrinking. I still believe that there will be fewer than 4,000 commercial banks in the United States by the end of the upcoming decade.
However, something new is going to happen at the other end of the banking spectrum. International banks are going to play a much bigger role in the United States in the future and this is going to substantially change the playing field and will help to accelerate the decline in the number of banks in the American banking system.
What’s going on? Just in the recent past we have had the news that the Bank of Montreal, the fourth largest bank in Canada, acquired the banking firm of Marshall and Ilsley Corp., which has $38 billion in deposits, 374 branches throughout the Midwest, and is the largest lender in Wisconsin. Then we learned that TD Bank, the second largest bank in Canada, is acquiring Chrysler Financial, the former lending wing of the Chrysler Corporation.
We also learn that Deutsche Bank AG and Barclays PLC have moved up the rankings of global business when compared to other Wall Street organizations. (See the Wall Street Journal article “New Banks Climb Wall Street Ranks,” http://professional.wsj.com/article/SB10001424052748703581204576033514054189044.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj.) These organizations have grown substantially filling in some of the hole left by the collapse of Lehman Brothers, and the moving of Bear Stearns and Merrill Lynch into other banking firms.
The point is that the American banking scene is much more open to foreign competition on its own turf in the 2010s than it was previously. This has the potential for causing even more changes in the structure of banking in the United States and in the world than we have seen over the last fifty years.
If we go back to the start of the 1960s, the United States contained some 14,000 commercial banks and a large, prosperous thrift industry. But, things were changing. Let me point out just three of the major factors impacting the banking and thrift industries by the start of the 1970s. First, was the beginning of the credit inflation that was to spread throughout the economic system that would result in the rising interest rates which would eventually bankrupt the thrift industry and drive it out of business.
Second, the United States commercial banking system at the start of the 1960s was a mish-mash of banking rules. For one, the branching laws were such that banks could not branch across state lines, and in some states banks could only have one office, in others they faced severe limits on the number of branches they could have, while in other states there was unlimited state-wide branching.
What broke this structure down? Information technology. With the spread of information technology banks could not be constrained from branching across state lines. The death knell for state control and limited branching was sounded. National competition became the new norm and banks had to compete.
The third factor was the freeing up of the flow of funds internationally. By the end of the 1960s the capital flows were basically unrestricted between the United States and Europe. One of the major signs of this openness was the creation of the Eurodollar deposit which became an important tool in the move to “liability management” which freed up American commercial banks from limits on their ability to grow their balance sheets. This factor contributed to the demise of the “Bretton Woods” system of international finance.
All three of these factors played a big role in the changes in the financial system of the United States and the world and to the movement away from “relationship finance” and “arms-length finance”. For more on the changes in the banking system and the growing “impersonal” nature of the financial system see the book “Saving Capitalism from the Capitalists” by Raghuram Rajan (the winner of the Financial Times/Goldman Sachs award for the best business book of the year, “Fault Lines”: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan) and Luigi Zingales, both of the University of Chicago.
All of these factors are still at work but we are now seeing another important factor coming into play, “competition from the outside.” Just as the forces inside the United States have been attempting to build up walls to constrain the finance industry, America is now coming to experience a breaking down of the barriers. Unless the Congress puts up restrictions on foreign financial interests acquiring domestic companies, it seems as if the door is opening for more and more banks from outside the United States to come knocking.
The result of this “opening up” according to Rajan and Zingales is that the new competition really “shakes things up.” I have contended throughout the events which began in late 2008 that by the middle of 2009 the largest 25 commercial banks in the United States had moved beyond most of the structural problems that contributed to the financial collapse. Furthermore, by the time that the Dodd-Frank Financial Reform bill got passed, these banks had moved beyond most of the onerous portions of the legislation.
Now with these foreign financial organizations moving into the competitive space of the United States banks, all banks will be using information technology and uncontrolled capital flows throughout most of the world to further outpace efforts of regulatory reform.
Another consequence of this will be the pressure on the larger banks to continue to merge and acquire and diversify their businesses in ways we have not yet imagined. And, when one brings into the picture the things that information technology can do and the progress the “Quants” have made in finance, one can only guess at how exciting the near-term evolution of the banking system is going to be.
Merry Christmas and Happy New Year to Everyone!
Most of my comments on the banking industry over the past year have been spent on the “smaller” banks, the banks are not among the 25 largest commercial banks in the industry, the banks that control about 30% of the banking assets in America. At last count there were a little less than 7,800 of these banks. The average size of the banks in this category is about $480 million, pretty small.
My concern about these banks is their solvency. The FDIC placed 860 commercial banks on its list of problem banks at the end of the third quarter. The question that is still outstanding is how many more banks are seriously challenged to remain in business. That is, how many banks are not on the problem list but “near” to being on the problem list. Elizabeth Warren gave testimony in front of Congress in the spring and stated that 3,000 commercial banks were threatened by bad loans over the next 18 months.
Commercial banks have been closed at the rate of approximately 3.5 per week during 2010 and many other acquisitions have taken place. So, the industry is shrinking. I still believe that there will be fewer than 4,000 commercial banks in the United States by the end of the upcoming decade.
However, something new is going to happen at the other end of the banking spectrum. International banks are going to play a much bigger role in the United States in the future and this is going to substantially change the playing field and will help to accelerate the decline in the number of banks in the American banking system.
What’s going on? Just in the recent past we have had the news that the Bank of Montreal, the fourth largest bank in Canada, acquired the banking firm of Marshall and Ilsley Corp., which has $38 billion in deposits, 374 branches throughout the Midwest, and is the largest lender in Wisconsin. Then we learned that TD Bank, the second largest bank in Canada, is acquiring Chrysler Financial, the former lending wing of the Chrysler Corporation.
We also learn that Deutsche Bank AG and Barclays PLC have moved up the rankings of global business when compared to other Wall Street organizations. (See the Wall Street Journal article “New Banks Climb Wall Street Ranks,” http://professional.wsj.com/article/SB10001424052748703581204576033514054189044.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj.) These organizations have grown substantially filling in some of the hole left by the collapse of Lehman Brothers, and the moving of Bear Stearns and Merrill Lynch into other banking firms.
The point is that the American banking scene is much more open to foreign competition on its own turf in the 2010s than it was previously. This has the potential for causing even more changes in the structure of banking in the United States and in the world than we have seen over the last fifty years.
If we go back to the start of the 1960s, the United States contained some 14,000 commercial banks and a large, prosperous thrift industry. But, things were changing. Let me point out just three of the major factors impacting the banking and thrift industries by the start of the 1970s. First, was the beginning of the credit inflation that was to spread throughout the economic system that would result in the rising interest rates which would eventually bankrupt the thrift industry and drive it out of business.
Second, the United States commercial banking system at the start of the 1960s was a mish-mash of banking rules. For one, the branching laws were such that banks could not branch across state lines, and in some states banks could only have one office, in others they faced severe limits on the number of branches they could have, while in other states there was unlimited state-wide branching.
What broke this structure down? Information technology. With the spread of information technology banks could not be constrained from branching across state lines. The death knell for state control and limited branching was sounded. National competition became the new norm and banks had to compete.
The third factor was the freeing up of the flow of funds internationally. By the end of the 1960s the capital flows were basically unrestricted between the United States and Europe. One of the major signs of this openness was the creation of the Eurodollar deposit which became an important tool in the move to “liability management” which freed up American commercial banks from limits on their ability to grow their balance sheets. This factor contributed to the demise of the “Bretton Woods” system of international finance.
All three of these factors played a big role in the changes in the financial system of the United States and the world and to the movement away from “relationship finance” and “arms-length finance”. For more on the changes in the banking system and the growing “impersonal” nature of the financial system see the book “Saving Capitalism from the Capitalists” by Raghuram Rajan (the winner of the Financial Times/Goldman Sachs award for the best business book of the year, “Fault Lines”: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan) and Luigi Zingales, both of the University of Chicago.
All of these factors are still at work but we are now seeing another important factor coming into play, “competition from the outside.” Just as the forces inside the United States have been attempting to build up walls to constrain the finance industry, America is now coming to experience a breaking down of the barriers. Unless the Congress puts up restrictions on foreign financial interests acquiring domestic companies, it seems as if the door is opening for more and more banks from outside the United States to come knocking.
The result of this “opening up” according to Rajan and Zingales is that the new competition really “shakes things up.” I have contended throughout the events which began in late 2008 that by the middle of 2009 the largest 25 commercial banks in the United States had moved beyond most of the structural problems that contributed to the financial collapse. Furthermore, by the time that the Dodd-Frank Financial Reform bill got passed, these banks had moved beyond most of the onerous portions of the legislation.
Now with these foreign financial organizations moving into the competitive space of the United States banks, all banks will be using information technology and uncontrolled capital flows throughout most of the world to further outpace efforts of regulatory reform.
Another consequence of this will be the pressure on the larger banks to continue to merge and acquire and diversify their businesses in ways we have not yet imagined. And, when one brings into the picture the things that information technology can do and the progress the “Quants” have made in finance, one can only guess at how exciting the near-term evolution of the banking system is going to be.
Merry Christmas and Happy New Year to Everyone!
Tuesday, December 21, 2010
Long-term Treasury Yields in 2011
Yesterday, I attempted to lay out how I thought 2011 would play out in terms of the value of the United States dollar. In “The U. S. Dollar in 2001” (http://seekingalpha.com/article/242766-the-u-s-dollar-in-2011) I argued that the general outlook for United States monetary and fiscal policy was more of the same policy stance that the United States government had taken for the last 50 years: credit inflation. (For more on this see the Financial Times/ Goldman Sachs business book of the year, “Fault Lines” by Raghu Rajan: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan.)
The year 2011 will follow the pattern of large fiscal deficits and monetary ease and this will carry into the foreseeable future. As a consequence, the long term direction of the value of the United States dollar will be downward. I focus on this initially because this sets the stage for how financial market participants view the actions of the United States.
This downward movement, however, will be interrupted in the short run by the continued problems relating to the sovereign debt of various countries within the European Union. The United States, in 2011, will still be seen as a refuge from risk which will result in the dollar being supported by a “risk averse” investment community through much of 2011.
The turmoil in Europe is taking the pressure off of the policy makers in Washington, since they will be free of any criticism that might come their way because of a declining value of the dollar. As a consequence, the Obama administration will not need strong leadership to execute an “unpopular” monetary or fiscal policy: this was the case in the late 1970s and early 1980s as Paul Volcker, leading the Federal Reserve, put the brakes on the economy and the value of the dollar rose significantly; and Robert Rubin, leading the Treasury Department in the 1990s, helped to bring the federal budget from a deficit to a surplus, which produced another significant rise in the value of the dollar.
So, my basic expectation for the economy for the next year (and for the near future) is similar to that being called “the new normal”. The new normal incorporates sluggish economic growth, high unemployment, and weak inflation. (See “Champions of the ‘new normal’ stick to their guns,” http://www.ft.com/cms/s/0/b9c8a49e-0c5b-11e0-8408-00144feabdc0.html#axzz18l9xj6XV.)
The sluggish economic growth of the United States will remain around 3.0 percent to 3.5 percent, year-over-year, something way below what ordinarily has occurred in economic recoveries in the past. This modest growth rate under-scores the structural problems exhibited in the economy, the unusually low level of capacity utilization on the part of industry, the fact that the under-employment rate will remain in the 20 percent to 25 percent range as employers remain reluctant to bring back workers on a full time basis, and the fact that the year-over-year rate of growth of industrial production has been dropping off every month since June 2010.
I do see three ominous clouds on the horizon present in the financial sector. First, the solvency problems in the smaller commercial banks will continue to linger. As readers of this column know, I believe that the Quantitative Easing on the part of the Federal Reserve is more to keep the banking system afloat as the FDIC closes a sizeable number of banks over the next year or so. This will keep a lid on bank lending.
Second, there are the financial problems being experienced by state and local governments and these problems spill over into the financial markets for the bonds of these entities. The implications of this situation for the reduction in budges are huge.
Finally, large corporations have accumulated a huge chest of cash (both in the United States and Europe). It is my belief that this accumulation of cash is for “buying” purposes and we will see a sizeable pickup in mergers and acquisitions as the economic recovery continues. But, this restructuring of the economy will not create more jobs and increase production. In fact, it will do just the opposite. Large banks will also participate in this expansion of mergers and acquisitions. And, the big will get bigger.
Overall inflation will remain moderate. The year-over-year rate of increase in the implicit price deflator of gross domestic product remains around 1.0 percent and this probably will not go much above 1.5 percent this year, if it goes that high. Thus, general inflation does not seem to be a near-term problem.
However, given the current stance of monetary policy we see the possibilities of bubbles forming all over the place. (See “The Fed: Bubble, Bubble, Everywhere,” http://seekingalpha.com/article/240732-the-fed-bubble-bubble-everywhere.) As we saw over the past 25 years or so, general inflation was low and policy makers felt under control of things. Yet we saw bubbles here and bubbles there. Now, the actions of the Federal Reserve are being picked up in a rise in commodity prices, rising stock markets of emerging nations, and the buildup of inflationary pressures in export driven countries like China and Germany.
Putting this all together, my view of long term Treasury yields for 2011 is up, with the 10-year Treasury security reaching 4.5% to 5% in the upcoming year, a rise from around 3.3% to 3.5% now. The 30-year Treasury security will rise to the 5.5% to 6.0% range, up from around 4.4% to 4.5% now. The spread between the yields of these two maturities will be about 100 basis points, slightly lower than it is at the present time.
Bernanke will not be able to keep long-term interest rates down!
This just puts long term Treasury yields back at the levels they were for much of the 2000s.
From this, I argue that the long run expectation for inflation built into these securities would be in the 2.0 percent to 3.0 percent range. For myself, I find that this level of inflationary expectations over the next ten to thirty years is low. But, that is another story.
The major uncertainties in this picture? The first uncertainty pertains to the stability of the banking system. I believe, however, that the Federal Reserve will continue to flood the financial market with liquidity in order to allow the failing banks to be worked off in an orderly fashion. If this occurs, the recovery will continue but at a slow pace.
The second uncertainty pertains to state and local finance. My feeling is that the federal government will not allow this situation to get out of hand. Welcome to the bailouts of 2011.
The third uncertainty pertains to the bubbles that have been created or are being created. As we have learned, bubbles can last only so long. The question will remain about how long the bubbles created will last. Given that the Fed will continue to flood the market with liquidity, it is unlikely that the world will be bubble-free.
One thing mentioned above I believe will be an uncertainty only in timing. That is the increase in the amount of mergers and acquisitions taking place. I believe that 2011 will see a continuation in the acquisition splurge that has already started and will continue beyond this coming year. The only uncertainty related to this is the reaction of the federal government to the bigger companies. My guess is that the new Congress won’t challenge this and the Obama administration will not have the will to challenge it.
The year 2011 will follow the pattern of large fiscal deficits and monetary ease and this will carry into the foreseeable future. As a consequence, the long term direction of the value of the United States dollar will be downward. I focus on this initially because this sets the stage for how financial market participants view the actions of the United States.
This downward movement, however, will be interrupted in the short run by the continued problems relating to the sovereign debt of various countries within the European Union. The United States, in 2011, will still be seen as a refuge from risk which will result in the dollar being supported by a “risk averse” investment community through much of 2011.
The turmoil in Europe is taking the pressure off of the policy makers in Washington, since they will be free of any criticism that might come their way because of a declining value of the dollar. As a consequence, the Obama administration will not need strong leadership to execute an “unpopular” monetary or fiscal policy: this was the case in the late 1970s and early 1980s as Paul Volcker, leading the Federal Reserve, put the brakes on the economy and the value of the dollar rose significantly; and Robert Rubin, leading the Treasury Department in the 1990s, helped to bring the federal budget from a deficit to a surplus, which produced another significant rise in the value of the dollar.
So, my basic expectation for the economy for the next year (and for the near future) is similar to that being called “the new normal”. The new normal incorporates sluggish economic growth, high unemployment, and weak inflation. (See “Champions of the ‘new normal’ stick to their guns,” http://www.ft.com/cms/s/0/b9c8a49e-0c5b-11e0-8408-00144feabdc0.html#axzz18l9xj6XV.)
The sluggish economic growth of the United States will remain around 3.0 percent to 3.5 percent, year-over-year, something way below what ordinarily has occurred in economic recoveries in the past. This modest growth rate under-scores the structural problems exhibited in the economy, the unusually low level of capacity utilization on the part of industry, the fact that the under-employment rate will remain in the 20 percent to 25 percent range as employers remain reluctant to bring back workers on a full time basis, and the fact that the year-over-year rate of growth of industrial production has been dropping off every month since June 2010.
I do see three ominous clouds on the horizon present in the financial sector. First, the solvency problems in the smaller commercial banks will continue to linger. As readers of this column know, I believe that the Quantitative Easing on the part of the Federal Reserve is more to keep the banking system afloat as the FDIC closes a sizeable number of banks over the next year or so. This will keep a lid on bank lending.
Second, there are the financial problems being experienced by state and local governments and these problems spill over into the financial markets for the bonds of these entities. The implications of this situation for the reduction in budges are huge.
Finally, large corporations have accumulated a huge chest of cash (both in the United States and Europe). It is my belief that this accumulation of cash is for “buying” purposes and we will see a sizeable pickup in mergers and acquisitions as the economic recovery continues. But, this restructuring of the economy will not create more jobs and increase production. In fact, it will do just the opposite. Large banks will also participate in this expansion of mergers and acquisitions. And, the big will get bigger.
Overall inflation will remain moderate. The year-over-year rate of increase in the implicit price deflator of gross domestic product remains around 1.0 percent and this probably will not go much above 1.5 percent this year, if it goes that high. Thus, general inflation does not seem to be a near-term problem.
However, given the current stance of monetary policy we see the possibilities of bubbles forming all over the place. (See “The Fed: Bubble, Bubble, Everywhere,” http://seekingalpha.com/article/240732-the-fed-bubble-bubble-everywhere.) As we saw over the past 25 years or so, general inflation was low and policy makers felt under control of things. Yet we saw bubbles here and bubbles there. Now, the actions of the Federal Reserve are being picked up in a rise in commodity prices, rising stock markets of emerging nations, and the buildup of inflationary pressures in export driven countries like China and Germany.
Putting this all together, my view of long term Treasury yields for 2011 is up, with the 10-year Treasury security reaching 4.5% to 5% in the upcoming year, a rise from around 3.3% to 3.5% now. The 30-year Treasury security will rise to the 5.5% to 6.0% range, up from around 4.4% to 4.5% now. The spread between the yields of these two maturities will be about 100 basis points, slightly lower than it is at the present time.
Bernanke will not be able to keep long-term interest rates down!
This just puts long term Treasury yields back at the levels they were for much of the 2000s.
From this, I argue that the long run expectation for inflation built into these securities would be in the 2.0 percent to 3.0 percent range. For myself, I find that this level of inflationary expectations over the next ten to thirty years is low. But, that is another story.
The major uncertainties in this picture? The first uncertainty pertains to the stability of the banking system. I believe, however, that the Federal Reserve will continue to flood the financial market with liquidity in order to allow the failing banks to be worked off in an orderly fashion. If this occurs, the recovery will continue but at a slow pace.
The second uncertainty pertains to state and local finance. My feeling is that the federal government will not allow this situation to get out of hand. Welcome to the bailouts of 2011.
The third uncertainty pertains to the bubbles that have been created or are being created. As we have learned, bubbles can last only so long. The question will remain about how long the bubbles created will last. Given that the Fed will continue to flood the market with liquidity, it is unlikely that the world will be bubble-free.
One thing mentioned above I believe will be an uncertainty only in timing. That is the increase in the amount of mergers and acquisitions taking place. I believe that 2011 will see a continuation in the acquisition splurge that has already started and will continue beyond this coming year. The only uncertainty related to this is the reaction of the federal government to the bigger companies. My guess is that the new Congress won’t challenge this and the Obama administration will not have the will to challenge it.
Monday, December 20, 2010
The United States Dollar in 2011
I still believe that the long term trend for the United States dollar is downward. For the near term, for 2011, I believe that the United States dollar will remain relatively strong, at least against the other major currencies in the world.
My reasoning for the belief that the long term trend for the United States dollar is downward is based on the fact that the fundamental economic policy of the United States has been and will continue to be one of credit inflation. I explain this stance using the following chart.
The general trend in the value of the United States dollar reflected in this chart is downward. If one begins in March 1973 when the value of the index was set at 100, in November 2010, the value of the dollar declined by 27 percent.
The decline in the value of the dollar since the United States floated the price of the dollar internationally in August 1971 is even greater. Rough estimates place the decline in the value of the dollar from the time it began to float against major currencies until March 1973 between 15 percent and 20 percent. This would place the decline in the value of the dollar since it was floated through November 2010 roughly at 35 percent to 40 percent.
The underlying cause of this decline in the value of the dollar began in the early 1960s as the fundamental philosophy of economic policy in the government shifted to one in which a low level of unemployment became the over-riding goal of the fiscal and monetary policies of Washington, D. C.
The immediate results of this shift in economic philosophy was the destruction of the existing “fixed-rate” international foreign exchange system as capital flows opened up throughout the world and it became impossible to maintain fixed exchange rates in the face of independent national economic policies. A world of credit inflation became the norm.
There were two interludes, that of the Volcker monetary tightening in the early 1980s and the Clinton efforts to balance the government budget in the late 1990s. These periods, however, were just temporary diversions from the basic economic thrust of the policies of both Republicans and Democrats over the full 1961 to 2010 period.
I believe that the longer term trend in the value of the United States is still downward because the fundamental economic philosophy of the United States government has not changed. Credit inflation is still the basis of any policy being proposed by the government and this has been re-iterated over and over again by the economic policy spokesman of the Obama administration, Fed chairman Ben Bernanke.
I expect that federal budget deficits over the next ten years will total more than $15 trillion and the monetary policy of the government will just support the placement of that debt over time.
I don’t see any leader in Washington with the foresight or the strength to build a more sensible economic policy. That is, I don’t see anyone “in place” or on the horizon to pull off efforts at constraint like we saw in the early 1980s or the latter part of the 1990s. Thus, the basic fundamental economic strategy of credit inflation will continue to rule Washington, D. C. for the indefinite future.
The thing that will arrest this decline in the value of the dollar in the short-run is the situation in Europe. In a real sense the United States dollar is being protected in the short-run by the fact that the lack of leadership in Europe exceeds the lack of leadership being exhibited in the United States. One does not see this situation reversing itself in 2011. The value of the United States dollar will not deteriorate further against the Euro (and some of the currencies of other major developed nations) in the coming year.
Here the scale is reversed from the above chart. The Euro weakens against the United States dollar in the early part of 2010 as the sovereign debt crisis worsened in Europe. Around June in the year some confidence picked up as the European “bailout plan” for some of the perimeter European nations seemed to be coming together. As the summer wore on, doubts arose about the potential success of the effort. This backing off continued until the speech administration spokesperson Bernanke gave at Jackson Hole, Wyoming putting forth the idea of what is now referred to as QE2, Quantitative Easing 2.
The European financial situation once again came to dominate this foreign exchange market as the problems in Greece, the accelerating political and economic problems in Ireland, were coupled with downgrades to Portuguese debt and this has now expanded to potential downgrades to Spanish debt and other “non-perimeter” countries like France and Belgium. Confidence in the leadership within the European Union continues to fall: this chaos is seen as the dominating drama still to be played out.
So to summarize: in the longer-run, the value of the dollar can be expected to decline. The reason is that the political and economic leadership of the United States does not seem to have learned much over the past 50 years. However, this decline will be further interrupted for a while as European leadership continues to exhibit its greater incompetency.
There is one other development that I think it will be important to keep one’s eye on and that is the growing movement to conduct world trade in currencies other than the United States dollar. We see that Russia and China have moved in this direction. Brazil is also interested in moving in this direction as are several other countries that have not made a “big deal” out of it yet. The important point is that the “rest of the world” seems to be moving without the United States. This is just another example of the receding influence of the United States in world economic affairs.
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